Radical Guide to Bonds: A Quick Introduction to Bond Laddering
Laddering is an old investment management tool. Laddered portfolios are equal amounts of bonds whose maturities come in equal intervals (like rungs of a ladder). The maturing rungs are then reinvested in the longest maturity of the ladder. In turn, the duration of the ladder is roughly maintained.
As an example, say an investor invests in 5 rungs, spaced out as 1, 2, 3, 4, and 5 years. The investor puts $20,000 into each rung of the ladder in high quality and liquid investments, for a total of $100,000 invested into the ladder. As bonds come due, the proceeds are reinvested in the 5-year rung.
Why do investors like ladders? The biggest reason is that a ladder is a reasonable held-to-maturity investment strategy. The investor invests and then waits for cashflow to come back. Investors like the fact, too, that as rates rise, an increment (a rung) of the total invested amount is redeployed in higher yielding assets.
Notice that no trading happens in ladders, only purchases. These purchases are timed events, whenever the redemption of one of the ladder’s rungs occurs. The laddered investor is not concerned about trading gains. Other points worth mentioning are:
- Laddered portfolios have definite cashflow. The investor will know when, and how much, cash is coming back. Tax liabilities should, as a result, be largely related to interest income. (The phantom income resulting from principal adjustments delivered on TIPs is treated as interest income, too, when the bond matures).
- Through selling groups and auctions, the trading costs of your ladder can be reduced. We can’t stress this point enough (first made in A Quick Introduction to Corporate Bonds): For a buy-and-hold bond investor, online corporate bond selling groups and Treasury auctions are cheap entry points into the market.
- One downside to bond ladders is the availability of product, at the right time, to fill out your ladder. When your bond is being redeemed, will you find the right product? Will the Treasury auction the right bond, with the right maturity, for your ladder when you need it? Timing is everything.
- Do you get enough diversification? In one of its marketing pieces, Schwab argues that investors should optimally invest in 10 different issuers. (See Further Reading.) With 10 bonds, the investor minimizes default risk. Still, not many individual bond investors have the wherewithal to own a ladder comprising 10 bonds. Alternatively, with higher grade issuers, the default risk is lessened and so the 10-bond threshold is less critical.
With a ladder, you have to be your own asset manager. That means you have to do your own credit analysis and reinvest the spinoff of cashflows from the ladder. On the other hand, you can pay someone to do that and depress your returns with manager fees.
Please read on as we discuss bond funds and other bond market vehicles in the next chapter.
June 3, 2005 | Permalink
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